Is This Natural Gas Play Undervalued?

Whenever a company is in the midst of a major transformation, there are lots of risks along the way that could potentially turn sour. So, as investors, we try to mitigate this risk by digging deep into these respective companies so we have as clear a picture as possible. InterOil has flown under the radar for a while, but it has big plans to capture the Asian natural gas market. Is InterOil an unspoken gem that the market is undervaluing? Or are its ambitious plans too big for the company to handle? Let's take a better look at these questions to get a clearer picture.

Undervalued?One of the reasons InterOil doesn't get much attention is its location. The entirety of the company's natural gas assets are on the island nation of Papua New Guinea. This doesn't make them any less valuable, though. The company owns leasing rights to almost 4 million gross acres in the country. A study done by GLJ Petroleum Consultants estimates that the company's acreage has as much as 6.0 trillion cubic feet of recoverable reserves.

If the company's estimates are correct, it is quite possibly one of the most undervalued assets around. This would give the company a market cap value of about $0.62 per thousand cubic feet equivalent of reserves. Compare that with Linn Energy's 4.7 Tcfe of proven reserves and market cap value of about $1.87 per thousand cubic feet equivalent of reserves.

Here's the catch: Not all of InterOil's 6.0 Tcfe are proven. Since its inception, InterOil has spudded 14 exploratory wells on all of its its holdings. While some of the initial production rates on these wells have been exceptionally high, they were immediately shut in. It is difficult to determine metrics such as the decline rate and the estimated ultimate recovery for these wells without their having produced for some time. It's also hard to determine the full potential of a 4 million-acre site based on a dozen exploratory wells and seismic mapping. While the potential for something great is there, it's still too early to give a final verdict on Interoil's prospects.

Overreaching?InterOil currently has two business segments that generate revenue for the company: its midstream and refining segment, and its retail and marketing operations. So far, almost all of the profits from these segments have gone into exploration and production. It has also used the sale of interest stakes in some of its upstream assets to help finance both its upstream operations and its initial efforts to build an LNG export facility. Unfortunately for the company, the proceeds from these operations aren't enough to fund its plans at a very rapid pace. This is why the company has for quite some time sought out partners to execute this strategy. It found two last year. Both the Papua New Guinean government and Colombian E&P company Pacific Rubiales took minority interest stakes in some of its exploration fields.

Still, this isn't quite enough. The company will need a large injection of capital to expand its exploration and production capacity, build out a pipeline network to deliver gas from its wells to its export facility, and build the LNG export facility itself. InterOil hopes to have LNG facility up and running in a three- to five-year time frame. One note of promise on this front, though, is that the company has received several bids from companies to be the partner on the export facility. Investors can only hope that it chooses a partner with deep pockets. ExxonMobil's own LNG facility in PNG has gone over budget several times. When it is completed, Exxon estimates that the project will have cost around $19 billion.

That's not to say InterOil's vision is impossible, but it will be very difficult and it will take several years to play out.

What a Fool believesThere are certainly some signs coming from InterOil that show promise for the company, but at the same time the company will need lots of capital, help, and time to fully execute its strategy. One concern the company will run into is fierce competition for Asian LNG exports. By the time the InterOil hopes to have its LNG facility up and running, several LNG facilities will be in operation:

Exxon's PNG facility will have the capacity to move 6.9 million tons of LNG per year and will be ready by the end of 2014.

There are 8 LNG export facilities either in operation or under construction in Australia. The headliner of these facilities is the 9-million-ton-per-year facility in Queensland. ConocoPhillips , the operator of this future facility, expects to send its first shipment in 2015.

Canada's National Energy Board recently approved the first LNG export facility in British Columbia. This project, co-owned by Chevron and Apache , will start with total capacity of 5 million tons per year, with a potential to expand to 10 million. The partners expect this facility to be operational by 2016.

By going up against such big players in the energy space with very deep pockets, InterOil could find the LNG export market much more difficult than originally anticipated.

For investors who are patient and have a high tolerance for risk, then perhaps InterOil should be on your watchlist. For someone looking for a safer investment in the energy space, then a company like National Oilwell Varco is hard to beat. It has almost 60% of the oil services market share and is positioned well to take advantage of markets both in North America and abroad. To help determine whether this company is a nice fit for your portfolio, check out our premium research report with in-depth analysis on whether NOV is a buy today. For instant access to this valuable investor's resource, simply click here now and claim your copy today.